Marcuard's Market update by GaveKal Dragonomics
Narendra Modi stands as India’s most powerful prime minister in 30 years with a mandate to pursue a pro-economic growth agenda. The reason to stay with the most compelling trade in emerging markets is that a clear reform impulse has been articulated while the capital spending cycle is showing signs of life. The problem for investors is that key choices on fiscal consolidation and specific reform initiatives may not be announced until a budget speech expected in early July. Nature hates a vacuum so it is not clear how the interregnum plays out.
Here’s what we know. India faces a stagflation problem. Growth in the year to March came in just below expectations at 4.7% while inflation remains stubbornly high with CPI in April at 8.6%. To arrest the malaise, Modi has promised streamlined and more effective government. Having a clear parliamentary majority means less need to dispense patronage so he has shrunk the size of his cabinet and will clip the wings of ministers by requiring important measures to be funneled through the cabinet office. It is hoped that centralizing measures overcome the bureaucratic inertia that has left big projects in limbo. To this end, the new Ministry of Finance has subsumed the former Ministry of Corporate Affairs, and will be headed by Arun Jaitley, a close Modi confidante.
Such moves augur well, but Jaitley faces a more immediate headache in the shape of a potential credit rating downgrade. The ratings agencies had warned that India could lose its investment grade rating unless a stable government was formed. Now the attention will turn to the fiscal consolidation approach to be pursued. India has been in breach of its self-imposed 3% fiscal deficit cap since the 2008-09 financial crisis and the provisional estimate points to a fiscal deficit of 4.5% in the year ending March 2014. However, Jaitley’s first budget could see the provisional numbers blow-out even further as the new government strips away accounting measures used by the outgoing government to make its fiscal management look better than it was. Hence, the budget speech will have to outline a vision for economic growth, while also offering a credible pathway to fiscal consolidation.
The expectation is that Jaitley will seek a phased fiscal contraction using recent evidence from Europe against an enforced dash to austerity. We expect to hear a message referred to in the European context as “Thatcherite Keynesianism”, i.e. a fiscal consolidation which is back-loaded, together with structural reform measures which raise the underlying growth rate. The appeal to the external agencies will be that government spending is being shifted from operational expenses toward revenue-generating capital assets.
What is unclear is whether game-changing reform initiatives can be unveiled next month. Without a parliamentary majority in the second chamber the Modi-led government will face difficulty legislating on divisive issues such as labor market reform, food procurement or liberalizing measures to support the moribund manufacturing sector. More likely, we’d expect the announcement of a goods and services tax, which has broad political support.
Such caution will undoubtedly disappoint some investors, but it should be remembered that grand policy initiatives only go so far. Sustaining the capital spending upturn demands implementation rigor. And this requires the central government to use moral suasion over state governments which have the power to block projects. State governments are often unwilling to cede their own fiscal autonomy, creating India’s version of “gridlock”. Our assessment is that the new administration is the best placed in years to break this. Hence, corporates in sectors such as infrastructure could face the unfamiliar situation of policymaking being a help rather than a hindrance. Those firms which have spent recent years repairing their balance sheets are fairly well placed to secure funding to restart stalled projects and eventually take on new projects.
More broadly, sustaining Indian equities’ strong performance requires earnings growth. Over the last four years corporate profitability has expanded at a measly 3% CAGR. As a result, the share of GDP going to corporate profits fell to 4.2% in the 2013-14 fiscal year, from a peak of 7.8% in 2007-08. An improvement in the policymaking environment and credible fiscal consolidation should provide the backdrop for a reversion to the long term mean of 5.6%.
On this basis (and assuming 10% nominal GDP growth) then companies should be able to generate earnings growth in the next four years of 18% CAGR. Although Indian stocks are starting to look expensive, at about 17-times trailing earnings, this is not an entirely unreasonable basis for staying with the world’s most compelling emerging market story. Such a positioning requires a sequencing of positive events, but stranger things have happened -- even in India.
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